Financing longer lives: Longevity funding issues and potential solutions

20 Jan 2011

As highlighted by other articles in this newsletter, longevity is increasing. Individuals in developed economies are living longer; while fertility rates are dropping, causing a worsening dependency ratio. Pension and long-term health care costs are set to rise considerably which will be a burden both for the public sector as well as pension funds. Governments and private sector pension providers will need to study means of reducing their financial exposure to longevity increases. One way is to look to insurance products to mitigate this risk.

Longevity risk for individuals is mitigated by purchasing annuity products or participation in a defined benefit pension scheme. The policies or benefits will provide regular payments for life – there is no danger of the well running dry. The costs associated with individuals living longer than expected are carried by the pension provider. A rise in longevity can increase the costs substantially. Underestimating life expectancy by just one-year – a relatively small miscalculation, it could easily be higher – can increase liabilities by up to 5%. For a pension plan with USD 1 billion of assets, an extra USD 50 million would need to be funded. Longevity improvements have been consistently underestimated over the last 30 years. Moreover, alongside longevity risk, private sector providers also face asset risk – and many have suffered substantial losses during the financial crisis.

Some or all of the longevity risk can be mitigated by pension providers. Many defined benefit pension schemes are, for example, now closed to new entrants. Many employees now have defined contribution pensions – they get what they put in, together with investment returns. Retirement can be postponed and this would involve supporting employees to stay longer in the work place and / or by decree through increasing the pension age. The latter is politically a lot more fraught than the former, particularly as the age profile of the electorate rises. None of these measures can be enacted quickly or deeply enough to prevent a pensions funding crunch in many states. Equally politically fraught and with negative economic connotations is to make tax payers or savers contribute more. The result is that a considerable pension funding gap is opening in public and private sector accounts. According to the OECD, 2100 exchange listed companies, from selected countries, have an average deficit of 26% in relation to their defined-benefit plan funding levels.

 

Factors which could increase longevity

Factors which could decrease longevity

Lifestyle

Fewer smokers
Improved diets
Regular exercise

Rise in obesity
More stress
Less physical activity

Medicine

Development of drugs tackling life threatening conditions, eg statins

Lower accident mortality

Discovery of effective gene therapy

Viruses and bacteria develop resistance to currently available drugs

 

Disease

Improved survival rates from eg cancer, heart disease

New diseases/viruses
Pandemics
Diabetes

 

 

 

 

 

 

 

 

 

 

Forecasting longevity risk

Forecasting mortality trends may be a much slower moving target than, say, forecasting share or bond prices. However, the further out one goes with any prediction, the greater the uncertainty. Certain mortality drivers can be sudden – for example, war or serious pandemic. The incidence of war or highly infectious diseases is currently much smaller in industrial economies than previously in human history. Most mortality trends in our more recent history take many decades to evolve and become clear only a number of years after they are underway. Prominent among these are lifestyle trends, for example our diet, our level of exercise, and how much we drink or smoke. Medical innovations and practice have also contributed to sustained mortality improvement.

There are, broadly speaking, two schools of thought among demographers about old age mortality. Some believe old age mortality is relatively plastic and that through a combination of medical progress and lifestyle changes the boundaries of life expectancy can be pushed ever upwards. There are others who believe there have been a number of impressive one-off mortality gains; but that there is a natural ceiling on human longevity we have reached or are rapidly reaching. The truth may well lie somewhere between the two.

Insuring longevity risk

There are three basic products pension providers can purchase to off-set their longevity risk:

  • Bulk annuities: These are insurance policies that, in return for an upfront premium, promise to pay members’ pensions until the last member or dependant dies.
  • Longevity insurance (indemnity longevity swaps): In effect, these products are similar to bulk annuities. The major difference is that the premium payments are spread over the duration of the pension payments, rather than being in bulk upfront. It allows pension providers to continue to manage the assets and underfunded plans to receive immediate coverage instead of waiting until sufficient funds are present for a bulk annuity. A landmark longevity insurance deal was reached between Berkshire County Council (UK) and Swiss Re in 2009.
  • Longevity swaps (index longevity swaps): These swaps are forms of financial derivatives which allow insurers to further divest their risk to other financial players. Swaps can be executed on either an indemnity basis, where the payout is directly linked to the actual payments by the pension provider, or on an index basis with payout linked to the observed longevity of a reference population, eg the population of England & Wales.

The most developed longevity insurance market is the UK. Here there are many defined-benefit schemes, disclosure of pension liabilities is highly transparent and annuitisation of defined-contribution schemes is effectively compulsory. Longevity insurance activity is less developed in other markets, but is expected to develop in certain countries with material exposures and a high level of private pension provision, such as Switzerland, the Netherlands and the US. With high levels of annuitisation, longevity exposure could be transferred to insurers and the need for reinsurance or other funding methods will increase.

Where longevity is the only major insurance risk it carries, an institution can transfer the risk and create a mutually beneficial partnership. The party accepting the risk can consolidate it with a diversified portfolio of other exposures, such as the natural offset of mortality risk. As such, the vast majority of recent longevity ‘hedging’ transactions has been absorbed directly or indirectly by reinsurers.

Providing capacity

Insurers have a finite capacity for taking on longevity risk and use this to offer annuities either to individuals or to employers in the bulk annuity format. In order to free up their capital to offer further solutions for their customers, they can pass on some of their risk to a reinsurer. The reinsurer would offer a transaction similar to longevity insurance, mentioned above, and enable the insurer to provide more annuities using the resulting freed up capital. With regulations such as Solvency II in Europe, these solutions will become increasingly important over the next few years.

While they can take on a great deal of longevity risk, reinsurers have insufficient capacity to take on all the risks that may ultimately be transferred, and would need to create additional capacity in the longer term. Although in their infancy, the capital markets may offer a route to do this. Insurers and reinsurers already diversify natural catastrophe risk to the capital markets, using cat bonds. These pay a coupon return; the risk taken on by the counterparty is the loss of part or all of the committed capital in the event of a pre-defined catastrophe.

Publicly-available mortality indices could be used as a benchmark for pricing risk-transfer deals, and there have already been some successful steps in forming a mortality risk market. Swiss Re’s Vita Capital mortality bonds – pioneered in 2003 to transfer life insurance risk to capital markets – have reduced Swiss Re’s exposure to ‘mortality shocks’ such as pandemics. A group of insurers, reinsurers and banks have set up the Life and Longevity Market Association (LLMA) to promote a liquid traded market in longevity and mortality related risk. The future potential of this market is further highlighted by the fact that Swiss Re recently completed the first longevity trend bond transaction by securitising USD50 million of longevity risk on the capital markets.

Overall, the market for longevity risk management solutions is still in its infancy. High profile deals in the UK have included those with BMW, RSA and Berkshire County Council. The transactions to date have all involved very large portfolios of business, but as product design and innovation have evolved, solutions suitable for smaller pension funds and annuity portfolios have become available. Historically, there has been little demand for reinsurance of longevity risk, so the reinsurance market has sufficient capacity for the time being. However, as price expectations between buyers and sellers of longevity risk are converging, opportunities for commercial transactions are growing, and more capacity will be needed. In the short-term, demand for reinsurance solutions is expected to increase and clients are turning to reinsurers’ capacity as a first port of call in the knowledge that an extensive capital market solution will take some time to develop.

A collective solution to a growing problem

No individual party can solve the looming pensions funding crisis on its own. A spirit of collective responsibility needs to be developed. Only through true public-private partnerships can we ensure the long-term sustainability of the world’s pension systems. Appropriate structures must be established, which can last long into the future. The insurance industry must play a central part in this and continue to provide solutions to address the risks held by individuals, employers and governments. While life expectancy is on the increase, the time required for implementing effective longevity funding solutions is running out. Insurers, governments and pension providers must take action now to ensure that all aspects of increased life expectancy remain positive for society.

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